“Are there schools focusing on students they shouldn't be...? Sure. But I think the majority, they're not doing that because it just doesn't make long-term business sense.”

A senior analyst at BMO Capital Markets, he covers the business and professional services industry. He's been following the for-profit colleges sector for more than a decade. This is the edited transcript of an interview conducted on Feb. 17, 2010.

This for-profit sector -- how does this all get going and when?

The sector's been around for a number of decades. We were talking about Apollo Group, which owns the University of Phoenix. It started in the 1970s. DeVry, [Inc.,] started in the 1970s. You probably have some schools that were before then, but I think the genesis of this industry really started off in the 1970s.

It was a niche-y environment then. Apollo's University of Phoenix, for example, focused on working adults. That was a sector that was really being ignored by the traditional schools that were out there. It started off small. DeVry was somewhat similar as well. But the 1970s into the 1980s, you started to see more acceptance.

The 1990s is where this sector really started to take off a little bit more. Wall Street started to get involved. DeVry went public in 1991. Apollo Group went public in 1994. It attracted a lot more capital because, from a business perspective, it's a great story. You're serving a market that's been traditionally underserved. There is a need for more education. And from a business and financial perspective, it's a very profitable business. It generates a lot of free cash flow, so it attracted a lot more financiers.

You say it's an extraordinarily profitable business and generating a lot of free cash flow. Can you spell that out a little bit?

One of the metrics that Wall Street uses is operating profit as a percentage of revenue. And it does vary by company, but generally you have operating margins in the mid-teens to as high as 25, 30 percent for some of these companies. You tend to skew higher profits the more the companies have more of an online business -- it's less of a fixed-cost business. Free cash flow measures the amount of cash that these companies generate.

What's nice about this business -- and this goes for the traditional sector as well -- for the most part, you get paid before you provide the service. And your credit, for the most part, tends to be the U.S. government. Title IV of the financial aid system represents probably somewhere between 70 to 80 percent of the cash that these companies get. So you get the cash up front from a cost perspective. If you price your products well enough, you can generate some profit based on the product that you offer.

How does that compare, those profit margins, to ordinary businesses?

I would say generally it's probably at the high end, at least in the for-profit sector.

So it's not just the profit margin that makes these things attractive. It's these schools are getting the cash up front.

That's one. Number two, from a bigger perspective, when investors look at a sector or an industry to invest in, they want to look at the growth potential over time. Is there a reason that these companies will continue to grow?

I think everybody would admit that the more education you get over your lifetime, the more money you're going to make, so it's an attractive feature from a market perspective. It's not a product that's going to be going away anytime soon.

Apollo, DeVry, they're pioneers in this sector? Maybe spell out the difference between them and technical schools, trade schools, and how they stood as something different, what kinds of educations they were offering.

Apollo and DeVry, for the most part, provide degree-oriented programs. You can get a bachelor's degree; you can get an M.B.A. At some of the schools, you can get a Ph.D. So they will compete, in essence, with the traditional universities in terms of the products that they offer. DeVry also offers some vocational programs. It's a small piece of what they do. But there are other companies in the space that specialize in that.

As a matter of fact, the for-profit sector, if you look at just the schools themselves, the majority of the schools tend to skew toward these vocational-oriented programs. And the value proposition there is very strong. They tend to serve a market of nontraditional students. These are not the folks that are going to go back to college, for whatever reasons. Maybe they can't afford it; maybe they're just not traditional students.

They're not going to go back to a traditional four-year school.

Correct, but they do need skills training. The more skills training you have, the more money you're going to make over your lifetime. So this is a sector of the population that's really being ignored by the traditional sector, but yet needs skill training to compete and make money and support their families. And I think that's the niche that the for-profit sector has really found and helped to grow.

You're starting to see some competition from some of the community colleges, going after a sector that they probably should have gone after, because from a demographic perspective, they're probably serving the same type of population. But the for-profit sector realized that this was an underserved niche and went after it a lot quicker than the community colleges did.

Why have traditional colleges underserved this group?

In terms of the four-year universities -- again, not to stereotype, but a lot of these folks probably will not thrive in a four-year university. A lot of them are working, so the four-year universities tend to have traditional hours, and they can't fit their courses into the traditional schedules. So I think just the flexibility of the for-profit schools have been a reason why they've been able to serve this sector a little bit better.

In terms of the community colleges, for the most part, the mantra there has been to take folks, give them a two-year education -- usually an associate [sic] degree comes along with that -- and then try to get them to enroll in a more traditional university. So take your associate degree, go to a traditional school, and get a bachelor's degree.

For the most part, they've not been interested in getting those folks into the career world, into the job market, just after two years. That's an area that the for-profit sector does specialize in.

But why didn't the traditional schools adapt to serve this group that you say is underserved if there's money to be made? And schools are constantly complaining about pressure; they're raising their tuitions all the time. Why weren't they able to see what [University of Phoenix founder] John Sperling and others at these schools saw?

I don't want to stereotype the whole traditional school system, but for the most part, their purpose in life is not necessarily to provide job training. Their purpose in life is to provide an education. Sometimes they go hand in hand; sometimes they don't. So the traditional sector, I don't mean to say that they've ignored this part of the population, but it hasn't been the area that they've focused on. They just think that they have a different mission in life than the for-profit schools do.

But you say the for-profits, like Apollo, offering B.A.s, master's degrees, even Ph.D.s, are competing with large state universities, certainly competing with the community colleges.

Sure. And I think the way that they compete is more on the flexibility side. So again, if you want to get a bachelor's degree or a master's degree, you have many options. The question is, how do you fit that into your lifestyle? The traditional schools, historically, have been very rigid. They've got their set schedules. Most of the classes take place during the day. You're starting to see a little bit more of the night classes and weekend classes, but when I was going to school and college, that didn't exist.

Talk about what you saw in terms of investment opportunities and the kind of growth that took place in those stocks.

I started covering this sector in the late 1990s, so I kind of got the tail end of that growth. But it was enormous. In terms of the market capitalization, the size of the companies, they were still fairly tiny then. Apollo ... was the biggest company in the space, but I think they barely broke over $1 billion in market cap, maybe toward the end of the decade. Now they're closer to about $9 billion.

But you had more and more companies going public. If I remember correctly, Career Education [Corporation] and Corinthian Colleges, [Inc.,] -- two other for-profit school systems that, for the most part, focused on the vocational programs, the associate degree programs, although Career Education's expanded a lot beyond that -- they went public in the 1990s as well. You had probably about six or seven companies toward the end of the decade that were publicly held, and they started to get on people's radar screens. You started to have analysts, like me, following the sector. It really became an industry in the 1990s, and it was taken to the next level this past decade.

So you have a whole new sector being born. Where is all the management and expertise ... coming from?

Yeah, great question. And that was a knock against the sector early on. Because it was such a new sector, how are we going to be able to develop management? I would say, if you look now at some of the management teams across the school systems, a lot of them came from University of Phoenix. They were really the 800-pound gorilla in the space then -- they still are now. Because they were so large and expanding, they had to keep on training new talent. Whether they got their new talent from the traditional school system, which I think from an academic perspective, that's really where the talent came from, but from a business perspective, you didn't necessarily see people that were working in business offices at traditional universities come to the for-profit sector. It's a consumer service business, so you tended to see people coming from other consumer service and consumer product companies.

There tends to be also a very heavy market focus, so in the marketing areas, you saw a lot of people coming from marketing backgrounds and consumer products, other industries, etc.

Another area that you started to see was technology. Especially the schools that were going online, they were taking management teams from other technology companies that were really at the forefront of what was going on from a technological perspective.

The consumer and technology industries were probably the areas where we saw the most management come from.

Can you give me examples of people that came through, either into Phoenix and then out to form other schools? ...

In terms of the Phoenix people, offhand, there's nobody I can name. If we skip to the 2000 decade, there are a number of current management teams that came from outside the industry, and I'll just -- may not be exactly dovetailing with what we just talked about, but for example, Gary McCullough, who is the CEO of Career Education, has a consumer products background. You have the folks that have been over at Corinthian Colleges. Peter Waller is another. He's the CEO of Corinthian Colleges; he also has a consumer products background. The prior CEO, Jack Massimino, actually had a health care background, which is an area that I neglected to mention. Health care being a very regulated industry, there's a lot of similarities between health care and education, so you've seen some folks come from health care as well. You have Rob Silberman, who is the CEO of Strayer [Education, Inc.,] that actually came from the government. If I remember correctly, he worked in the Department of Energy. Again, kind of that regulatory theme, having that background.

So if you look at the management teams across the industry now, I would say it's more common to probably see people coming from outside the industry as opposed to people that have been homegrown within the industry. I think that's been one of the benefits, is that we've been able to bring a lot of different perspectives to this sector than what we had beforehand.

Was there any concern on Wall Street that there were very few people that were educators involved in these education companies?

I guess I was referring to the executive management teams. For the most part, most of these companies are organized with two silos. You've got the business silo and the academic silo.

But in traditional universities, many of the university presidents are academics or former academics. So there is a difference here?

There is a big difference. ... They're businesses as well as academic institutions. I don't necessarily think that the traditional schools, for the most part, see themselves that way. So the for-profit schools wear two hats, while the traditional schools maybe only wear one.

Talk about the price difference between going to a University of Phoenix as opposed to the University of Maryland.

On the price scale, the private, not-for-profit schools tend to be the priciest, especially when you include the Ivy League schools there. Next would come the for-profit schools, and then at the bottom of that would be the public, not-for-profit schools. Now, that's in terms of just tuition, or cost of attendance.

The reason that there's a big price differentiation is, for the most part, at the not-for-profit sector, specifically the public not-for-profits, the majority of their funding does not come from student tuition; it comes from endowments. The state schools get funded by the states; the community colleges get tax revenues from their counties or local municipalities. The for-profit schools, 85 to 90 percent of their funding comes from tuition.

But that comes from government loans, most of it.

It comes from government loans, state grants, corporate reimbursement, but students have to pay out of pocket as well. But yeah, the government grants do fund the majority of the schools across the spectrum.

But when you look at the tuition per se, it's a little bit misleading, because from a taxpayer's perspective, you think, "Oh, well, if I look at a community college, and it only costs $3,000 to $4,000 a year to educate somebody, and I look at a for-profit school that maybe costs $15,000, why would anybody go there?"

From a taxpayer's perspective, it may actually cost you more at the end of the day to fund an education at a community college or a state school when you include the state funding, when you include the tax revenues from the counties and municipalities.

So in other words, those schools are heavily subsidized, and you're not seeing those costs?

Correct. But the out-of-pocket costs for a student tend to be more at a for-profit school than a traditional, public, not-for-profit school.

One of the things that concerns people, rightly, is the high cost of education, and that four-year colleges especially, that those tuitions are going through the roof, and that for-profits, too, are charging more and more. Why?

One: The costs themselves have been going up. For traditional universities, if you look at the bulk of the costs, a lot of them are research institutions. The public not-for-profits fund hospitals, themselves. You also have the tenure issue. The cost of labor is a sizable cost at public not-for-profits. You don't necessarily see that on the cost side at the for-profit institutions. Most of them don't have research institutions; they don't have hospitals; they don't have tenure.

So when you compare the bottom line, so to speak, of the for-profit schools versus the not-for-profit schools, there's a lot more money flowing down in the for-profit schools because they don't have these costs.

I don't think historically the traditional schools have thought about running their schools as a business, because they've always been able to get outside financing, grants, endowments, donations; you name it, it's been there.

In a bad economy, those pipelines have really shriveled. You're starting to see traditional schools focusing on their cost structure a little bit more. In a recession, ... demand actually increases for a lot of programs in a recession, so for-profit schools, some of them do better in a bad economy. At the same time, their competition is getting weaker from a financial perspective. So the costs are going up for everybody, but I think the for-profits, because they run their schools as businesses, probably can manage it a little bit better.

Where are we going with this trend? I mean, we've got, what, 10 percent of students going to for-profit schools now?

Roughly, yeah.

Where's this going?

Historically, the market share gains have been sizable. A decade ago or so, the for-profit share of the overall enrollment market was probably about 2 to 3 percent. I think over the past 10 years, the for-profit sector, in terms of enrollment, has grown about 11 percent per year. Traditional higher education has probably only grown 1 to 2 percent.

That's why we've seen this market share shift to the for-profit sector. I think you still will see that share shift going forward. I don't think it's going to be 10, 11 to 1 to 2. You're probably going to see maybe the for-profit sector grow about 4 to 5 percent a year. Traditional education, because of demographics, probably continues 1 to 2 percent a year.

But I still think you'll see the for-profit sector continue to gain share. Again, they run these schools as schools, but also as businesses. You don't see not-for-profit schools building new campuses, expanding their geographic presence for the most part. The for-profit sector will expand. That's a reason that they'll gain share.

I don't think it will ever go that high, but can you get somewhere close to 20 percent over the next decade or so? I think that's feasible.

So these schools, and 4 to 5 percent growth, Wall Street likes that?

You know, 4 to 5 percent growth would be slower than what we've seen over time, especially in a bad economy. We've seen some of these companies grow enrollments high teens, over 20 percent. Ironically, 4 to 5 percent growth would be considered slow, at least within the context of the way that these companies have been growing.

Part of the problem is that you've got to balance growth and quality. Some of the companies historically that found themselves growing a little bit too fast probably weren't focusing on the quality of education as much as they should have been. I think those companies learned a lesson, and you're not seeing companies run into as much trouble now as you did five or six years ago.

What do you mean by that? What kind of trouble were they running into?

We had issues where companies were expanding a little bit too quickly. There were allegations against some of the for-profit schools of enrolling people that shouldn't have been enrolling, folks that, for whatever reason, even though it is an open enrollment policy, shouldn't have been in higher education. They were bad students for whatever reason. They were folks that had financial issues and weren't able to come to school. For a whole host of reasons, you probably had some companies that were pretty aggressive on the enrollment side, and I think that's [scaled] back a little bit, because I think what Wall Street and some of the investors in this sector have realized is that these are good businesses. There's no reason to have both feet on the accelerator. These companies will grow naturally. You don't necessarily have to be as aggressive as some of the companies were a few years ago.

Talk about the role of marketing, especially compared to the traditional schools -- the role of marketing, the amount of marketing, the percentage of money spent on marketing at the for-profits.

When you go to traditional schools and you use the word "marketing," for the most part it's anathema to them. That doesn't really exist. The quote unquote "marketing budget" may be minuscule. They may include the people that work in the admissions office as part of marketing. But actually going out and marketing their schools was something that was foreign to a lot of these schools.

That's changed a lot. Maybe I'm overly sensitive to this, but every time I travel and I go into an airport, one of the first things I do is look at billboards that I see. I can't remember the last time I did not see a billboard from a traditional school in an airport, where 10 years ago, that never existed.

So you're starting to see more and more of the traditional schools market themselves. With that being said, it pales in comparison with the amount of money that the for-profits spend in terms of marketing. Again, it's to some extent a business. They need to continually add students, especially if they are expanding, opening up new locations, adding programs that the market wants -- again, another advantage of the for-profit sector, because they can add programs probably a little bit quicker than the not-for-profits do.

But as a percentage of revenues, you probably see somewhere around 20 percent of revenues being spent on marketing within the for-profit sector. It varies by school. It's a much smaller percentage for the traditional schools.

Twenty percent. That's including not just marketing but lead generation.

Sure. I would probably divide it in half. Half of it is being spent on the enrollment counselors, your admission advisers, that work within the organizations. Roughly the other half is spent on advertising, buying leads, advertising in trade rags, going to conferences, etc.

How does that compare with what they spend on the curriculum and faculty?

It's probably roughly the same. Obviously it depends on the company. There are some companies that spend more on what they call the instructional costs and services line. I would say the majority of the companies actually do spend more on the instructional costs and services relative to marketing per se. But marketing is probably the second biggest expense on the income statement.

... Somebody will hear that and say: "Well, wait a minute. They're spending a lot to get people to come to their school, but then they're spending about as much or, in some cases, less on the service they deliver." Is that a concern? Does Wall Street care about that?

... There's actually I think only one publicly held company that spends more on marketing than instructional costs and services. But for the most part, marketing is their second biggest expense. So the question is, should they be spending more on instructional costs and services -- the quality of their education -- than they do on marketing? Yeah, I would say that they should. And I would say any business probably should be spending more on actually developing and improving their product as opposed to going out and selling their product. But you look at the software industry. The software industry spends a lot more on sales and marketing than they do on R&D [research and development].

So it's a little bit different, because you're competing against the traditional sector where, again, marketing is really unheard of. From an academic perspective, to see a school spending money on marketing, it's foreign. And it does rub a lot of the traditional schools, and maybe traditional folks, the wrong way to some extent. But I would say there's a balance, and as long as you can keep that balance in perspective, it's not as much of an issue as you might think.

Yesterday I talked to a former manager at Apollo who said that they always spent more on marketing and enrollment counseling and financial aid counseling than they did on faculty.

I think that's actually changed if that's the case. I don't have the numbers in front of me, but as I said, if you go through the publicly held companies, there's only one that I remember offhand that does spend or has historically spent more on marketing than instructional costs and services. University of Phoenix is not that school. They do spend more, but marketing is probably the second biggest line [item].

And the question comes up as to whether the students' best interests are aligned with the shareholders' best interests.

I would say, as an investor, as a shareholder, you want to make sure that you're putting out a product that the market wants. If you're putting out a product where the education is subpar, nobody's going to want that product. So from a long-term perspective, as long as you keep on investing in your product, in the quality of the product, I think it's a better long-term investment.

Obviously you're going to have to market that product. You're going to be always spending something on marketing. But if you're ignoring investing in your product, it would not be a good long-term investment. I think the investment community has realized over time [that] growth is important, but investing internally is probably more important.

And how does Wall Street respond to the numerous anecdotes that keep coming up, that are reported widely, of students who get out of one of these universities and find that they have a degree that isn't worth as much as they thought it was going to be worth, and that they owe a lot of money?

I think that's an area where the industry has actually done a poor job countering that argument, because I think with any company you can always find a customer that's not going to be satisfied.

In this industry -- because again, it's not a traditional industry. Because it's an academic institution, when you find students that have had a subpar education or had a bad experience, it makes a great story. So you're going to see more and more on those than you have seen historically.

I've been following this sector for over a decade. You're always going to be able to find students that are unhappy, and you're going to find them talking about it, because somewhere in the media, it sells papers; it sells magazines; it sells programs. Unfortunately, there's always going to be a disproportionate amount of negative stories in this sector than positive stories. It's an unfortunate instance, but I think the investment community has gotten used to it.

Do you ever look at these and say, "Wait a minute," and go back to the company and say, "What's happening here?"

Yeah, of course we do. We're not going to ignore it, especially when you find the same kind of complaints against the same schools. As I mentioned earlier, five or six years ago there were some of the more aggressive schools -- ... it would be week in, week out, you would see another negative story. You don't see as many negative stories now; there's still plenty of them. It was more of an issue then, because it was so rampant and so new. Unfortunately, I think there's been so many negative stories that maybe Wall Street is desensitized to that to some extent.

And you say that the schools have not done a good job of countering with their own anecdotes of success perhaps. Why?

I think they've been focusing on growing their business; they've been focusing on handling the regulatory environment. They have not been focusing in as much on the public relations sides of the business as they should have.

I think that's changing. You're starting to hear companies and some of the trade associations involved starting to talk about, "Hey, we have a good story here," especially in an environment where [President Obama] wants to have more people going back and getting college degrees. The traditional institutions are under so much financial pressure that they will not be able to handle that influx. We've got a good story to tell; we've got a product that can help the president out. From a quality perspective, maybe it's not an Ivy League education -- I think most of the schools will admit that. But for what they offer, I think it's pretty good quality.

So you get to 2000, and you've got an explosion. Talk about what happened.

You had the recession that officially ended in late 2001; the unemployment rate peaked in 2003. These companies, even the countercyclical ones, for the most part were still growing enrollments into 2004 and early 2005. So for the first half of this decade, it was a great time to be operating a for-profit school. We probably had a few IPOs [initial public offerings] over that time, but for the most part, most of those occurred in the 1990s. The investment community, Wall Street, early in the decade was hiding here. These were great companies; these were great stocks; they were doing well --

Was hiding here?

They were hiding here. They were basically saying, in a recession and a down economy, let me find a sector that's countercyclical; let me find a sector that's going to grow. This was one of the few. And they did very well. They were gaining a lot of share; they were very profitable.

You started to run into some issues [in] 2004, 2005, where growth was slowing, whether it was because of the law of large numbers, whether because the economy was picking up and the unemployment rates were shrinking. Then you started to see some companies probably doing things they shouldn't have been doing -- going after student populations that maybe did not deserve to go to school, were [not] going to succeed in school. They were focusing on enrollments more than the quality. I think some companies will admit that they took their eye off the ball.

But isn't that the pressure of Wall Street?

Whether it was the pressure of Wall Street, whether it's the pressure of the companies themselves thinking it was pressure of Wall Street, for whatever reason, it happened. Shouldn't have happened, but it did.

It was painful to go through that process. I think it's actually made the industry healthier, because the companies themselves -- whether they're publicly held or privately held -- realized that this is a good enough business that you don't have to go crazy. You don't have to market yourselves like it's the end of the world.

But when you get really big and you have an enrollment like the University of Phoenix at 450,000 students, you've got to do a lot of marketing just to keep up.

Yeah. I mean, if you think on average that the length of stay is four years, you're turning over your enrollment base 25 percent per year.

And actually, they don't have their students staying for four years.

Sure, the students come in and out all the time. So when you think about it, in order to grow on top of the folks that are leaving, you've got to add the equivalent of one to one and a half Ohio States per year. That's why you've seen companies like this expand their programmatic offerings.

For example, University of Phoenix five or six years ago was dominated by bachelor's, master's and above. They developed a program they called Axia [College] at the time, which was an associate's degree program where you really did not see associate's degrees being offered online. They, in essence, invented that market. It's now about 45 percent of their enrollment base, about 200,000 students.

What you find that the more savvy companies do, they find new areas. They find new students to go after; they find new programs to develop where, [at] the traditional schools in terms of the curriculum development, it takes years to roll out a new program. You can find some of the for-profit schools rolling out new programs in less than a year. They're more at the forefront of what the market wants than the traditional sector. It's another reason that the for-profits grow faster.

Can they hold up quality and roll out new curriculum that fast?

That's always the issue. I think the reasons that the traditional schools are a little bit slower is, who develops curricula at traditional schools? They may have a central department that does that, but for the most part, it's the professors themselves. At the for-profit schools, for the most part there's a centralized curriculum development area, so just getting a product to market is a lot easier when you centralize it as opposed to having it diverse like you see within the traditional sector.

But it's not that they're rolling out products and just throwing it at the market. There is a process they have to go through. They have to get the accreditors' approval for that. They have to get the state license approval for the most part as well. There always are people looking over their shoulders to make sure that quality is up to par.

One of the great advantages that these for-profit schools have is that they don't have a tenured faculty.

Correct.

So in many ways, they are a movement that relies on, as some people have put it, union busting. If you consider tenured professors as a kind of union that bestows rights to the professors, it's all taken away in the for-profit model.

Well, think about who the for-profit sector, for the most part, is serving. Especially the online schools, they're focusing on the working adult market. These are people that are working now. The only reason they're going back to school is to enhance their skill set. And they want to make sure that they're getting the most up-to-date skills that the job market wants.

Who's better at providing that? Is it some Ivy League academic that hasn't worked, that's maybe just sat in their tower? Now, again, I went to an Ivy League school, I had some great professors, but if I really wanted to understand what's going on at the forefront from a career perspective, I'd rather have somebody that's working in that job, in that career every day.

But at the same time, these schools, in order to continue to maintain their student body and satisfy Wall Street, in many cases by continuing to grow, they go for a younger and younger cohort. Now, when they get into the 18-, 19-, 20-year-olds, they're in direct competition with community colleges and large state universities, aren't they?

Yeah, but I would say for the most part, the demographics of for-profit schools actually skew higher than they do at traditional schools. You have seen, for instance, ... Axia going down market, so to speak, in terms of going after the younger student. But even within the Axia program, if I remember correctly, their student body, the average age is somewhere in the low to mid-20s. So they may have some 18- to 19-year-olds. What they found, though, is that in order to have a good class discussion or a good class interaction, you'd rather have people that are in the working world; 18-, 19-year-olds maybe don't have the type of experience that they can provide to have a valuable class discussion. So for the most part, for-profits still focus on older students.

And there's enough of a market still?

Oh, yeah. If you look at, I believe, 75 percent of the U.S. population over the age of 25 does not have a bachelor's degree, so there's a sizable untapped market out there. I'm not going to say 100 percent of people over 25 will get a bachelor's degree, but it certainly should be more than 25 percent.

Talk about the schools going online and what that meant for the business.

First of all, how do you develop or attract a market? You want to go where that market is. And for the most part, the working adult students -- you started by offering classes at night and on the weekends. But if you wanted to be even more flexible, you had to have products and services and programs that were available online.

University of Phoenix was really the first for-profit school that really attacked that market. I believe they started their first online program in 1989, if I remember correctly, before the Internet really existed, so to speak.

How do you do that?

They did it more through correspondence classes, through other types of technologies. In terms of having a Web-based offering, that really didn't come until the 1990s. But University of Phoenix has really been at the forefront of that.

"Distance learning," they called it.

Distance learning, correct. The nice thing about that, again, is that one, you can develop products for the market that wants them; you can provide those products when they want those products. Two, in terms of making sure that they're up to date, it's a lot easier to enhance and modernize an online curricul[um] -- your e-textbook, so to speak -- than it is a traditional textbook.

My kids in school are using probably a math book that was written 50 years ago, and when you're offering online classes, you can bring in what's going on, current events, etc., online a lot easier. So just in terms of enhancing the product line, having an online capability gives you a leg up as well.

I think the traditional schools, some of them have started to go online, but for the most part, they've really been behind the curve, because again, it's not what they're used to. From a curriculum development perspective, it's very difficult to get them all on the same page. We've seen some traditional schools try to develop online programs. University of Illinois was one; NYU [New York University] back in the 1990s did as well. And unfortunately, they were failures.

Why?

They threw a lot of money at it a lot of times. It was backlash from the tenured professors. They didn't want to open up their classes to the masses, so to speak. They wanted to make sure that they just had more control. You had a lot of tenured professors that were very reluctant to let the school take their curricula and put it online. Even the ones that did, a lot of times all they did was just repurpose those courses online. They took something that was in a textbook, maybe you put it into a PowerPoint presentation, and that was it.

There's a lot more to online learning. I've taken an online class. Plenty of people that I've talked to have taken an online class. You work a lot harder in an online class than you do in a traditional class, and I think that surprises a lot of people. You can't just sit in the back of class and fall asleep when you're online. Most of the programs, you'll have the class, but there also is a class discussion where there's mandated contributions. Most of the schools mandate that five out of seven days you have to contribute something to the class discussion.

In a traditional school, in a traditional classroom, you don't necessarily have to work as hard. I think the traditional schools that went into the online education area just thought that we could just take what we have, throw it up on a Web site somewhere and we'll succeed. And that's far from the case.

Talk about it in terms of the business model and the numbers.

From a business perspective, when you're ramping up online, obviously there's the investments in technology that you have to make. But the nice thing about that is that once you've made that investment, a lot of the costs are made up front, and in essence, you can leverage that cost over a longer time period. You don't have the bricks-and-mortar cost. If I wanted to expand online, maybe you have to market yourself a little bit harder, but the amount of money that you have to spend is much smaller than it is when you're actually expanding a campus.

Can you give me that in a per-student-cost sort of formula?

I don't have that offhand, but generally the pure-play online schools make more money than the traditional schools, so we'll look at it that way. When we're looking at operating margins, operating profit as a percentage of revenues, if you're a pure-play online school, you can probably make operating margins in the 30-plus percent range.

If you're a pure campus-based school, maybe your operating margins are only in the high to mid-teens. ... Every sector you look at, an online business tends to be more profitable than a traditional bricks-and-mortar business, and that holds true here as well.

I hear, though, that it doesn't hold students as well, that there's a problem with retention with online. What's that about?

Yeah, retention is lower online. One of the reasons is because the advantage of being able to attract students that want that flexibility, it's hard to hold somebody's hand when they're taking an online class.

Part of the whole advantage of going to a campus-based university is the campus environment: having other students that you're actually interacting with, per se; talking to your professors; being able to go down the hall to the financial aid office and the registrar's office, making sure that my monies, my financial aid's OK, [and] I'm taking the right classes I need to be taking in terms of graduating.

When you're online, you could be sitting alone in your bathrobe at night, so a lot of online students tend to feel lost. Some of the better online schools, specifically the for-profit schools, have realized that it's one thing to get the students in the door; it's another thing to hold them. A lot of the companies actually have not only enrollment counselors, but they have online academic advisers, where they make sure that they call the students that are taking classes: "How's it going? Is everything OK? Do you have what you need to continue on going forward?"

Staying on top and providing that customer service is, I think, an area where the for-profit schools have been at the forefront. It's going to cost them more to do it, but at the end of the day, if you hold onto a student longer, you're going to make more money that way, too.

It seems like a very low-risk business to me, given that the money's up front and it comes from the government.

The risk is the government, and let's talk about that.

It's a highly regulated industry, so yeah, you can rely on the U.S. government as a good credit that hopefully the money will always be there. But there's always issues in terms of how that money is going to get there. Is it coming through grants? Is it coming through loans?

There's talk now about getting rid of what's called the FFELP program, [Federal Family Education Loan Program,] where you've had traditional banks, Citibanks, the Sallie Maes of the world, acting as conduits to provide that financial aid. In theory, they could all be gone six months from now.

They'll be gone, but then the money will still come directly from the federal government.

Correct. But the issue is, historically the service of getting that money in time has been lagging. You've seen, in terms of customer service, students complain that, "I'm supposed to start school on Sept. 1." When you go through the FFELP program, pretty much that money's there within a week or so. On the direct lending side, historically it's taken a little bit longer, so there's been some complaints along those lines.

On the back end in terms of the defaults, there have been some complaints that the schools that have been using direct lending as opposed to FFELP lending, the default rates have been higher. There's some data that counters that as well.

So there's some issues in terms of the funding environment, especially in this economy, where you see federal budgets being cut virtually across the board. Are Title IV loans and grants going to be cut? Right now, hopefully not. The Obama administration really wants to promote access, so hopefully they'll continue to promote that access, but there's been concern over time that Title IV funding will be cut.

There's also a myriad of regulations that are involved. And there's probably more regulations on the for-profit sector, over time, because you had some bad players 10, 20 years ago. There's specific regulations that the for-profits have that the not-for-profits do not have, just to make sure that we keep an eye on them a little bit more.

For example, there's something called the 90-10 rule, where if you're a for-profit school, you cannot have more than 90 percent of your cash receipts coming from Title IV funding. That does not exist at a traditional university, and the reason for that is that they wanted to make sure that the students realize that, OK, I can't fund my education 100 percent; I have to be able to be willing to fund 10 percent of my education. Maybe the quality of that program needs to be good enough that I'm willing to spend 10 percent out of pocket.

It's getting some buy-in from the students.

That's exactly it. You say this is a low-risk industry from an accreditation perspective and a regulatory perspective. There are always issues that these schools have to go through. We're going through one right now.

There's a process called negotiated rulemaking that I know you're familiar with, the "neg reg" process. A lot of the potential changes that they're discussing will have a disproportionate impact on the for-profit sector. So yes, there's a lot of benefits to being a regulated industry, but there's also a lot of negatives as well.

How does Wall Street assess the Obama administration's attitude toward these for-profit schools?

One of my clients uses the term, "There's a new sheriff in town." If you look over the Bush administration over the past eight years, it's been a fairly friendly administration to the for-profit sector, although there were some onerous regulations that were made during that administration as well, so I can't say that it was a completely lovey-dovey.

But it was a Republican administration.

It was a Republican administration. They tend to favor businesses, and this is a business to some extent. So for the most part, it was a favorable environment.

To a great extent, it's a business.

To some extent -- right, to a great extent it's a business, but to some extent, the environment was favorable. I think what you've seen with the Obama administration -- and it's not necessarily coming from the White House; it's probably coming from the Department of Education -- that there are folks involved at the Department of Education; for the most part I don't think there's a negative bias against this sector, but there are probably some people that if you took them out and had some drinks with them, you'd probably see that there is some negative bias against this sector. And that's understandable. Again, it's a nontraditional sector.

I think with a Democratic administration in the White House, with a Democratic-controlled Congress, this is a window that may not be around too much longer given the way things are going. So there are some folks in the Department of Education thinking: "You know what? This is our opportunity to make some changes. Let's do it now."

And what do you think they're going to do? Or what do you fear, let me say?

One of the biggest issues, there's something called "gainful employment," and it's a regulation that for the most part only applies to the for-profit sector. It applies to the not-for-profit sector if you provide non-degree programs, but it applies to the for-profit sector virtually for any program that you provide. So it's a disproportionate impact on the for-profit sector.

There is some talk about using that regulation to tie student debt levels to future earnings. Now, stepping back from a public policy perspective, I think this is a great thing to do. I think this should be done for all schools -- not-for-profit, for-profit. As a taxpayer, as a parent, student debt limits have gotten out of hand. I would love to see some sort of way of equating debt to the value that you're getting.

So that you're not getting a degree for $50,000 that gets you a $15,000-a-year job.

Correct. Now again, not everybody goes to school, especially in the traditional sector, to get a job. They're going to school to get an education.

But if you're going to a for-profit school, you've been marketed the idea that you're going to get a job with the education that you get.

Correct. So you need to be able to prove that value proposition; I agree. And like we were talking [about] earlier, for the most part the schools that have failed historically or have underperformed historically are the ones that cannot provide that value proposition, where the tuition got out of hand, or the quality of the education wasn't as good as it should have been.

... The way that the current regulations have been proposed, there are some flaws in the methodology. They're asking for a tremendous amount of information for the schools -- both the for-profit and not-for-profit schools -- to collect that they just don't have. They're trying to use a formula that equates debt to income, but they're only looking at a three-year period, and they're looking at a small piece of salaries. Somebody that's going back even to get a for-profit degree, they're doing it to get the lifetime benefit; they're just not doing it for the first three years out. So we can argue over the methodology. Again, I think it's a good thing to do from a public policy perspective, but there's a lot of unintended consequences the way this law's been proposed.

What kind of programs are going to be affected by this regulatory push?

Obviously if you've got a program where the cost of attendance is very high, the debt levels are very high, where the income you make is relatively low, those are going to be affected. The poster boys for this have been the culinary programs -- cooking schools -- where on average, some of these programs cost $40,000 to get an associate degree. For the most part, you're not going to be making close to that when you get out. You may be making something close to $30,000. The way the formula is written now, that would violate the gainful employment [regulations], and in theory, those programs would not be eligible for Title IV funding program -- so programs like that, where there's a disproportionate relationship between cost and earnings.

Other programs that have been cited have been associate degrees. Historically, for the most part, associate degrees have been the stepping stone to get a bachelor's degree. There are not that many associate degrees that you can go out and get a good job with, so there's a disproportionate relationship between the amount of debt that you take on when you just get an associate degree, and then you go out into the working world. The earnings premium is not that strong. That's another area that could violate these gainful employment regs.

And that would really hurt the for-profits in that they have had to expand into this area of offering associate degrees.

Correct. There are a number of for-profits where a sizable piece of their enrollment base are in associate degrees. I.T.T. Education is one. Right now, Apollo Group's University of Phoenix is another one. Again, there's a lot of nuances in the calculations, so maybe it doesn't affect them. There are also some exemptions. But generally, for-profits have been expanding in associate programs.

Ironically, the lower-end programs -- and I don't mean anything disparagingly against those schools, but the ones that don't provide degrees, that provide diplomas or certificates, allied health, medical assistant, etc. -- the value proposition actually is pretty strong because they're short-term programs. You don't take on that much debt, and the amount of earning bump that you get by having that diploma is commensurate with the amount of debt you get on. So those actually do fairly well when you're looking at these new gainful employment regulations.

I've talked to some people on the Hill in Washington and lobbyists for traditional schools. There's a lot of hostility toward the for-profit sector. Some of them see them as basically loan-churning companies that are masqueraded as education companies. Why so much hostility?

I think it has to do with history. You had a lot of bad players 20 years ago in this sector, and unfortunately they gave this sector a bad name, which is another one of the reasons we've had some of the more onerous regulations just apply to the for-profit sector.

I think, though, if you look at the management teams that are involved, whether they're publicly held or privately held, they realize that they don't have to do the things that some of their predecessors did 20 years ago to have good businesses. So the relationship is getting better, but there is still a lot of baggage; I won't deny it.

There's people who say that we're selling a lot of these students short, that we're steering them toward a second-tier education, that we should do more to encourage people to get a general liberal arts education.

Well, again, let's focus on the sector of the population that the for-profits are serving. For the most part, the for-profit schools have open enrollment, so if you really want to go back and get a traditional education, there are plenty of traditional schools that offer that. There are some for-profit schools that do as well, but for the most part, that's not what they do. They're more career-focused. The type of folks that they're focusing on are those that want to go back to schools and get career-oriented skills. If you want to get a liberal arts education, I think you would be better served by going to a traditional school.

Many people are uncomfortable with talking about education as a business and the offerings as a product.

I think, again, that goes back historically. But when I step back and look at the K-12 sector, who makes money off the textbooks? It's the McGraw-Hills of the world. There have always been businesses serving the education sector. Maybe they've not been involved in the actual teaching as much as you've seen in the for-profit sector, but I think the reason that the for-profit sector has done so well is that they focused on a market niche that really was being ignored by the traditional sector.

If there was not value here, you wouldn't see University of Phoenix have 450,000 students. It may not be for everybody, but certainly for a sector of the population, there's value.

We're seeing a lot of four-year schools get into financial trouble, aren't we?

Yes.

What's happening there?

These are mostly the traditional not-for-profit schools, whether it's funding being cut -- state and local tax revenues tend to drive a lot of the state schools and community colleges, so that pipeline's dried up. From the private universities, their endowments have been underwater. A lot of times, they invested in things that they shouldn't have invested in, and those investments have gone sour. So you can't rely on that buffer that the traditional schools used to rely on.

Also, because the traditional schools don't operate as businesses, they probably haven't focused on the cost side of the equation as much as the for-profit schools have. When the for-profit schools see enrollment growth slow or enrollments declining, they'll cut costs. You haven't seen that historically from the traditional sector. It's changing, but historically, for the most part, you've seen bloated infrastructure when you compare them to the for-profits.

What kind of schools are getting in trouble? What are we talking about here, and how many of them are we talking about?

In terms of numbers, I don't have the specifics, but anecdotally, you're seeing some number of private institutions -- a lot of the privately held, small liberal arts schools that don't have the big endowments -- are closing.

What's interesting is that you're seeing some of them being converted to for-profit schools. That's kind of a new area of growth, where historically schools that have had good-quality education, a good brand name, a good regional accreditation that tends to be considered the higher level of accreditation, but financially, because they weren't run as well as they should have been, they're running into trouble. You're seeing business people from the for-profit sector coming in and converting that model to a for-profit institution, saving the school -- yes, making money, true -- but at least giving those folks a viable option that you may not have had otherwise.

So you're seeing turnaround specialists, in a sense, operating in the education sector?

Correct. And that's something new. We've seen a couple of IPOs that actually started off like that four or five years ago, two that I know offhand. There's a company called Bridgepoint Education. They have a school, I believe headquartered in Iowa, that was a traditional, not-for-profit school that ran into financial problems. This company really helped, turned it around. There's another company called Grand Canyon Education that owns Grand Canyon University, based in the Arizona area. Again, a traditional school, very well known in the Southwest, but had some financial problems. This team came in and turned that company around as well.

And this team was?

The team right now that's running it is a group of ex-University of Phoenix folks. The prior team that invested, it was a private equity firm. And the same thing with Bridgepoint; it was a private equity firm. I believe it was Warburg Pincus that funded Bridgepoint.

And what was [education entrepreneur] Michael Clifford's role in those turnarounds?

Michael Clifford was kind of the visionary behind that, bringing in some of the folks from the private equity world to turn that around. I know he's involved in some other start-ups as well. He's done a lot of good work for a lot of these not-for-profit institutions that have run aground, in essence. He's made money, sure, but he's actually helped save a number of these institutions.

So he's a kind of phenomenon that's new in this sector?

He's been doing this since the early 2000 decade. So it's been around about seven, eight years.

Right, but in this decade we have this emergence of this kind of person, and just describe a little more of what we're talking about here.

Michael's unique. He's a real entrepreneur. You've got other people that have kind of followed the same framework, where it's people that believe in education but also believe in making money. I don't think there's anything wrong with that. We do live in a market environment, so if they can in essence provide a dual benefit, why not?

Are we going to see more of this?

Because this is a highly regulated industry, you're not going to see one on every street corner. You've got to go through a very detailed academic and accreditation process in order to get this done. It is not easy. If I remember correctly, there's been about 15 or so of these not-for-profit conversions. I think you will see more over time.

And so the sector will continue to grow?

Another growth engine for this sector.

It's fascinating, really, to watch these guys operate. And again, you say that there is an alignment between the interest of the student and the interest of the shareholder. A lot of people will squirm at that. They look at the subprime housing market, how it got out of control, and a lot of people were marketed loans which they should not have been marketed.

Sure.

And there's a worry that in the education world, people are being marketed loans that they shouldn't be taking on.

I think if you're focusing on a low-income student, and you're trying to get them to spend $100,000 on a bachelor's degree in English that may not get them anywhere -- now, again, I don't mean to stereotype, but if it's somebody that for whatever reason can't get into a traditional school, and a for-profit school comes along and offers them a bachelor's in English for six figures, I could see why people would be against that.

That's not what these schools do for the most part. For that kind of student, somebody that doesn't fit the traditional mold, they will try to put them in a program that serves them best, that gives them a better education that they can use [to advance] their career skills. Now, are there schools focusing on students that they shouldn't be focusing [on] and putting them in places that they shouldn't be putting [them]? Sure there are. But I think for the majority of the schools, they're not doing that because they've realized it just doesn't make long-term business sense.

How does it work? If you want to buy a failing school, how do you find one?

The Department of Education does have a list of schools that don't meet what they call the financial responsibility ratio, where those are companies or schools in essence that have some financial problems. I know some of the more savvy private equity investors historically have looked at that list to find potentially attractive investment opportunities.

Again, these are schools that are traditional schools, have pretty good reputations from an academic perspective. For whatever reasons they've been failures or near failures from a business perspective. So if you can save the schools from a business perspective -- which a lot of the private equity firms, that's their expertise -- and just piggyback along the institutional quality that these schools have, it's a win-win for both programs. So that's one area where we've seen some of the more savvy entrepreneurs focus on.

Because you essentially can find a school that has a good brand. It may not be doing financially well, but it's got a name. So some of the schools on this list are schools that we would recognize?

They tend to be more local or regional schools, so you would recognize them as being a local, regional school. They're probably not national schools.

Is that going to change as endowments wither, as state funds wither?

Sure, it might. You might see some brand-name schools really having trouble meeting the financial responsibility ratios. It could happen. I can't tell you who that's going to happen to. For the most part, it's been the smaller schools, but in this environment, you never know.

So as an analyst, looking out into the future, that's your job?

It's another area of growth opportunities. If, God forbid, one of these traditional schools really runs into financial problems, could I see a for-profit institution partnering with them to help turn them around? Sure. Could be another area of growth.

I sat in on a session where one of these schools was being bought, and it seemed that the big thing here was having the accreditation, rather than building the school from the ground up.

Right. We were talking earlier about the risks of this sector, and I mentioned the regulations were one of the risks. It's also a big barrier to entry. One of the things investors look for is that, are there barriers to entry to deflect other competitors from coming in? Accreditation is a big one.

Not so easy to get.

Not easy to get at all.

But once you have it --

Once you have it, it's not that easy to lose. There have been occasions where schools have lost their accreditation, but it doesn't happen often.

So if I'm looking down the list of schools that are in financial trouble, what I'm shopping for is a school I can turn around that's accredited. And that accreditation is --

Is key. It's a very valuable piece of why you're investing. And there's actually two types of accreditation. There's what's known as regional accreditation and national accreditation. It's a bit of a misnomer, because for the most part, a regionally accredited school is considered a higher-quality school.

Like the Harvards, Yales.

Harvard is regionally accredited. But so is DeVry. So is University of Phoenix. Same type of accreditation that the Ivy League schools have. So if you can find an underperforming traditional school with regional accreditation, that's a very valuable property. One specific reason, especially if you want to go online: Most students that go online don't necessarily start and finish at the same place. The reason they're going to go online is to take a class here, take a class there when they can. But they want to be able to transfer those classes to other institutions. Regionally accredited programs are more easily transferable. So a for-profit investor would probably rather invest in a regionally accredited school than a nationally accredited school if they wanted to go online.

Let's say we go out and we buy a failing school, turn it around, get rid of tenured faculty, put it on a for-profit basis, and attach an online department to it. Who's watching out for the quality? Who am I accountable to at that point? The accreditation is hard to lose.

Yeah, the crediting body is still there. And for the most part, with the model you've seen, is that they haven't necessarily changed the campus model other than put in more financial constraints. They don't necessarily come in and get rid of all the tenured professors, because you don't want to do that. If you're going to come in and in essence blow up a model -- yeah, it ran into financial problems -- you don't want to mess around academically. You want to keep that.

But what happened to Grand Canyon [University]? A lot of those teachers were tenured, and now they're not.

I don't think that's necessarily true. I still think they have a sizable portion of tenured teachers at the campuses.

Now, when they went online, they went after a different market. They're using adjuncts again because they're going after a different student that sees the value in having the adjunct professor that's closer to the job market. At the traditional school, I don't think you really saw dramatic changes in terms of the faculty. What they do is, in essence they take that platform and then build an online program on top of that.

Well, one of the owners of one of these schools at Grand Canyon talked about branding. He talked about the school, the bricks-and-mortar campus as a brand, and that you can take that and put it online and attract far more students than you could accommodate at your bricks-and-mortar campus.

Sure, I think there is some value to that. I mean, Harvard's a brand. Whether they admit it or not, the traditional universities have their own brands as well.

Harvard is not in big financial trouble.

Thank God. But there are probably other --- maybe not the Ivy League schools, but maybe other traditional schools that are seeing some financial problems.

University of Illinois is an example of a school. Talk about that one.

University of Illinois, maybe not from a financial perspective, but they instituted something a few years ago called the Global Campus.

Well, they were looking for a little bit more return.

Correct, but they were also looking to expand their market per se. Again, maybe taking a business perspective -- unfortunately I don't have all the specifics at my fingertips, but it did not work well. I know there was a lot of faculty resentment. Again, a lot of the faculty, the professors think that: "We own our curricula. These are our courses. We want to just serve our traditional student base. We don't want to expand what we have."

So there was an issue there of expanding the curricula. From a marketing perspective, University of Phoenix is a great brand. But again, if you're just going to repurpose what you have in a classroom on a Web site, it's not going to work.

Is the University of Phoenix a great brand when you compare it to, say, the University of Illinois at [Urbana-Champaign]?

I would say for the market that they're going after, yes. If you're going after a working adult student that wants a flexible education, I think University of Phoenix is a stronger brand than University of Illinois. If you're going after a traditional student that wants to get a traditional education, University of Illinois is probably the stronger brand.

So there's a lot of elitism here, isn't there?

That's always been the problem. We were talking earlier about some of the biases against this sector because it's an academic sector, and combining business and academics doesn't hold water to a lot of people.

For instance, you would not have gone to an online, for-profit university.

It's funny you should say that. I would say, first of all, it didn't exist when I was going back to school many, many years ago. But I have taken online classes. And now if wanted to enhance my education, maybe I wouldn't go there for my full M.B.A., but taking a class here and there, I think there's a lot of value in that. But I'm not necessarily their target market. Their target market are the other 75 percent of the U.S. environment that does not have a bachelor's degree.

That's a remarkably high figure. Most people aren't aware of that. Or at least most people that might be watching FRONTLINE tonight are not aware that 75 percent --

It's pretty scary. Now, I would say the younger generation, it's probably a lot smaller than that. Maybe 25- to 30-year-old is a little bit higher [percentage] than that. But generally, when you look at the demographics, that's the number.

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